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What do high quality earnings look like? – Part 1

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What do high quality earnings look like? – Part 1

It is clear that reported earnings are used as an input into investment decisions. It also logical that high quality earnings are better than low quality earnings. But how does one define what high quality earnings are?

The Statement of Financial Concepts (SFAC) No.1, puts forward the ways in which readers of financial statements use reported earnings, including: “to help them (a) evaluate management’s performance, (b) estimate “earnings power” or other amounts they perceive as “representative” of long-term earning ability of an enterprise, (c) predict future earnings, or (d) assess the risk of investing in or lending to an enterprise.”

In the comments section below I’d encourage readers to leave their thoughts on how they define high quality earnings for a business, and what characteristics of earnings they prefer for companies they invest in. In a follow up post, I will explore some of these thoughts and give further colour on ways to think about earnings quality.

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George joined MGIM in September 2015 as a Research Analyst. Prior to joining MGIM, George was an investment analyst at Private Portfolio Managers where he covered global equities across various industries, using a value investing framework. George’s prior experiences include equities research and investment banking roles at both Citi and Greenhill & Co.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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3 Comments

  1. Another segment or category of companies/cashflow types – Cashflows that come with low friction marginal growth.

    Looking at a CF statement – these two might look the same

    1. A consultancy business – Requires new people to bill their 1.5x salary in order to grow. Each point of growth comes risk, hassle, interviews, jokes you have to laugh at, training days, culture integration etc etc. The upside/downside equation is weak.

    2. A online retailer – Simply add a new domain (from .com.au to co.uk) and sprinkle a series of new words into digital marketing. The upside/downside equation is strong.

    The above are extreme examples to portray a point. But growth from marginal activity is something companies internally grapple with.

    Outsiders/Investors often think about growth being quite linear, whilst within companies it is never the case. Growth comes in step changes, with tipping points around capacity and other hurdles. Some industries have more hurdles than others.

    Putting the above into company examples – Cardno vs City Chic (on the ASX’s Black Friday sale)

    Mark

  2. Hi George

    I would define quality earnings as earnings that are highly likely to be sustainable going forward and have had a track record of growing over time at a rate of at least twice the rate of inflation, but preferably more.

    The characteristics I prefer most when investing in Companies are earning that have a high conversion to Free Cash Flow and have been generated from a Capital light Balance Sheet. Earnings and Free Cash Flow that can deliver Fully Franked Grossed up Dividend yields of about 4% are also attractive in the current low interest rate environment.

  3. Earnings driven from a value proposition, rather than a expense/tax, i.e. A can of coke or media subscription (something of small % discretionary income) vs a toll road, utilities, and commodity type goods.

    Given the customer feels they are winning (goods are cheap vs the value they provide), the cash from a CVP type product also comes with brand equity, enabling further cash generation through verticals and wider brand monetisation. Where a CVP is there or better still, recently created – Management 1) probably know a thing or two and 2) Probably think about the investor Value Proposition (allocation of capital) equation.

    CVP’s generated from a first mover advantage should be sidelined, unless the first mover advantage is critical to that industry/product, i.e. list based websites.

    In theory there shouldn’t be companies without a CVP, however monetary policy and the rise of Zombie companies make these more and more prevalent.

    Buffet summaries this as “Companies who can raise their price”. Same same re CVP theory, i.e. raising price indicates there is still room within the CVP equation.

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